Occasional Daily Thoughts: 2022 First and Second Quarter (P)Review

By LaRue Gibson on April 5, 2022

The first quarter of 2022 did not continue the bullish trend the previous four calendar quarters began. The S&P 500 Index had a total return of -4.6% to begin the new year. It seems every investor asks the same questions:

• Will the Federal Reserve regain the upper hand versus inflation?
• Will the economy fall into a recession?
• What about the war in Ukraine?

As for the war and its geopolitical implications, we defer to foreign policy experts to provide guidance. Instead, we will closely watch data in hopes that we glean meaningful insights into how risk markets discount the landscape in Europe.

Data provide a roadmap for what taming inflation requires from the Fed. The below chart illustrates that to break the inflationary trend in prices, the Fed has raised the Federal Funds Rate above its preferred measure of inflation, the Personal Consumption Expenditure.

Obviously, the Fed has work to do as it tightens monetary policy. The data suggest that recessions follow when the Fed Funds Rate exceeds the PCE Deflator. The devil being in the details, we cannot predict how long it will take to get Fed Funds over the PCE Deflator; how Quantitative Tightening affects inflation; and/or whether the Fed will have the constitution to tackle inflation as doing so may have great risk to the economic expansion.

The focus of the inflation debate centers around supply chain disruptions, agricultural products (food and fertilizer), and war-induced energy supply shortages; and while these factors influence inflation, we believe a paradigm shift occurs as we write. This paradigm shift recognizes that globalization has begun to contract meaningfully as populism, tariff regimes, and increased tensions between democracies and autocracies leads to more persistent inflation and will likely emphasize inflation-sensitive assets and the companies leveraged to these assets.

The expansion of globalization over the past 30 years led to disinflation in developed economies. In fact, the United States’ secular disinflationary trend and its associated investment themes were largely the symptoms of expanding globalization. According to Rich Bernstein of Richard Bernstein Advisors:

Globalization altered the global economy exactly as economic textbooks said it would: a more open global economy allowed production to move where it was most efficient. Few considered the US’s bulging trade deficit a problem because increased global competition and more efficient production imparted deflationary pressures on the US economy. Economists frequently stated that the US was “importing deflation” because import prices were rising more slowly than the overall US Consumer Price Index. Today, the trade deficit continues to expand, but import prices are now rising faster than those in the overall US economy. In other words, the US is now importing inflation, which is a significant difference from the trends of the past decade.”

As globalization wanes, we surmise that secular inflation may surprise investors to the upside ushering in a change in the prevailing thematic investment paradigm since the Great Recession. The predominate themes of long-duration assets, assets for which valuations are highly dependent on lower long-term interest rates, including growth, technology, innovation and disruption themes, cryptocurrencies, residential real estate, and longer-term fixed income will give way to inflation-sensitive market participants. These include energy, materials, industrials, commodities, commodity-related countries, gold, and some real assets. Interestingly, the combined market capitalization of the energy and material industry groups equals one Apple or one Microsoft! We remind our readers that opportunity is greatest where capital is scarcest.

Data suggest that earnings and yield multiples contract as inflation rises. This contraction may prove quite pernicious for long-duration investment assets.

Meanwhile, full employment, job openings, accumulated corporate and personal savings, and still-accommodative monetary policy might argue against a recession in 2022, yet the odds of a recession in 2023 will increase as the Fed may have little choice but to reduce monetary accommodation until significant progress is made on inflation.

In the face of mounting challenges, we wish to remind you that second calendar quarter historically has provided the second best average quarterly return of the four calendar quarters.  Preparation of thinking protects investors from emotional decisions.

It is worth noting, though, that when the first calendar quarter logs a negative print, we have observed below average 12-month forward performance.  Furthermore, readers of our research will remember our admonition about outsized corrections during mid-term election years.  We do not believe the first quarter market action represents the mid-term correction we expect as this correction rarely has occurred this early in the year. 

On average, midterm election years have experienced a 19% intra-year decline in the S&P 500 Index while non-midterm election years have experienced only a 13% decline.  Fortunately, these selloffs have turned out to be great buying opportunities because stocks are higher one year later every time and by an average of 32%.

The spread between earnings yields and treasury yields allow us to measure the equity risk premium. Currently, the size of the equity risk premium suggests that the equity market provides sufficient value to provide above average forward growth; however, we remind you that just a few short weeks ago, the Fed had not raised interest rates and it continued to buy bonds to support its Quantitative Easing regime. They have only just begun to tighten monetary policy. Martin Zweig famously opined “Don’t fight the Fed!” Until recently, perpetually negative real rates meant that virtually all stocks, regardless of valuation, were better alternatives to bonds for those seeking higher absolute returns. With long-term rates now rising, we believe a better alternative to bonds exists: relatively short-duration equities that have the cash flow to pay dividends and buy back stock.

Having written that, we follow the data. The data opine that forward returns at current equity risk premium levels skew to the above average type. To us, this data suggest any correction in 2022 provides a pause that refreshes and an opportunity for the thoughtful investor who will not anchor their opinions in past investment regimes.

Finally, allow us to provide perspective on the yield curve inversion that occurred as the first quarter ended. Since the beginning of 2021, we have remained resolute that market yields will move higher over time, and they have. Our base case continues to call for higher market yields, but we recognize that when the facts change, our prognostications may need to adjust as well. Of note, market yields have dropped, historically, once the 2-year/10-year Treasury Note yield curve inverts.

2022, like most years, does not disappoint in offering undulating currents to confuse and entice.  We endeavor to keep you focused on what the data communicate.  Since the days of Paul Volker, developed economies enjoyed disinflation as globalism allowed cost efficiencies to prevail.  As globalism contracts, we expect inflation-sensitive assets to take the mantel of leadership.  And while the Fed remains accommodative until rates exceed the neutral rate, bringing inflation to heel may kill the economic expansion.  Expect to read more about these issues and others as the year unfolds.  Thank you for your confidence and patronage.  Do not hesitate to call with any questions, thoughts, or concerns.  Please follow our social media accounts for our latest thinking in between our reports.  Take good care.

Below please find quarterly statistics for your review provided by our friends and partners at Strategas Securities, LLC.